Over the next month, banks will be releasing results for the second quarter. In advance of these releases, let's take a moment to review the state of some of these banks as of the end of Q1.
When I evaluate banks, I follow a model made famous by former Wachovia CEO John Medlin: soundness, profitability, and growth. As investors, we then look at valuation and the potential for investment after gaining a better understanding for each bank.
Soundness refers to the bank's asset quality. Generally speaking, this means loans. If a bank makes loans that are never repaid, that bank will fail, and fail quickly. The best banks put risk management first, ensuring that shareholder capital is protected if a portfolio of loans turns sour.
To measure this, we'll look at both non-performing assets and BB&T's provision for loan and lease losses. A simplified definition of non-performing assets is loans or other assets that have fallen seriously delinquent or are in foreclosure.
The provision for loan and lease losses is a reserve of money that the bank pulls out of its income each quarter to guard against future losses in the loan portfolio. Banks are required by regulation to maintain certain levels of reserves, but within that, management has plenty of wiggle room to over- or under-reserve. Over-reserving increases protection but hurts net income; under-reserving increases risk but keeps net income high.
For the quarter ending on March 31, BB&T had 0.53% non-performing assets as a percentage of total assets. The FDIC reports that banks with total assets greater than $10 billion on average had 1.5% non-performing assets as a percentage of total assets.
BB&T reserved $60 million for the first quarter, which represented 2.6% of operating revenue. That compares with 5% for the $10 billion-plus peer group, according to the FDIC.
On the whole, BB&T seems well positioned from a soundness standpoint. The bank played heavily in the real estate market leading up to the financial crisis and has struggled with those portfolios. BB&T was born out of community banks in the southeastern U.S; it makes sense that the bank would continue operating like those community banks, with concentrations in real estate, mortgages, and construction.
The bank's non-performing portfolio is on the decline, and the bank has reserved plenty of capital over the past few years to manage those bad loans out of the bank. This is evidenced by the below-peer addition to the reserve in the first quarter. Expect that trend to continue.
As that portfolio winds down and the bank's reserves are released, BB&T is well positioned to prosper. The bank brings an old-fashioned, community bank-styled risk profile to a regional bank level.
After establishing an understanding of a bank's risk culture and soundness, next we can focus on profitability. Any investment in a business is an investment in that company's future earnings, so profitability is a particularly important consideration for any bank investor.
The first question, perhaps most obviously, is whether the bank generates a profit at all. According to data from the FDIC, 7.3% of U.S. banks failed to generate a profit at all in the first quarter. That's one in every 14 banks!
For BB&T, the first calendar quarter of 2014 wasn't that bad. The company generated total net revenues of $2.5 billion for the quarter -- that's total interest income plus non-interest income minus interest expense.
Over the past 12 months, BB&T has generated $9 billion in total net revenue. Of that revenue, 60% was attributable to net interest income, the difference between interest earned on loans and paid out to depositors. The remaining 40% was through fees, trading, or other non-interest revenue sources. This breakdown is loan heavy, another indication of the bank's simple, community banking roots.
The bank was able to turn a profit margin of 22% on that revenue, about average for banks with more than $10 billion in total assets in the quarter.
For the first quarter, the company reported return on equity of 10%. Of the banks covered in this series of articles, the average return on equity was 8.9%. The FDIC reports that the average ROE for U.S. banks with total assets greater than $10 billion was 9.1%.
Taken all together, BB&T performed well, but not exceptionally so. The bank's business model is stable and consistent but won't produce the outsized profits -- or volatility -- that may come with more complex banks. Keep in mind that the wide swing from 2008 to 2012 spans the worst real estate and financial crisis in a generation. On the whole, BB&T performed about as well as one could hope.
I view the simplicity as a positive, prioritizing the consistency over the headline-grabbing quarters -- both positive and negative.
Leverage is a double-edged sword for banks and could easily fit into either the soundness or profitability categories. We'll call it a subset of both and discuss it here.
Leverage is just part of the game with banks, so if you're a conservative investor who really focuses on conservative capital structures, the banking industry may not be the best place for your money. Adding leverage is an easy way to juice return on equity, which is, generally speaking, a good thing. The bank increases assets and thus earnings, while maintaining a lower capital level.
The result is a higher numerator, a constant denominator, and a larger return-on-equity number. The math does the heavy lifting for you.
On the flip side, too much leverage can put the bank on thin ice if the loan portfolio takes a turn for the worse. A stronger equity base protects the bank from bankruptcy and bailouts, two outcomes that are both politically charged and downright terrible for shareholders.
Banks use all kinds of esoteric and overly complex accounting methods to determine leverage. We'll keep it simple here with an old-fashioned assets-to-equity ratio. The lower the number, the less levered (and more conservative) the bank.
BB&T's assets to equity ratio comes in at 7.8. The average of the 62 banks analyzed in this series of articles was 9.1.
BB&T's below-average leverage is an interesting counterpoint to the run-of-the-mill return on equity that I discussed earlier. Management is again taking a conservative approach, particularly in light of the still elevated levels of non-performing assets.
Growth and valuation
BB&T saw its revenues change by 3% over the past 12 months. That compares with the 5.7% average of the 62 banks analyzed.
This change in revenue corresponded with an 11% increase in net income over the same period. The peer set averaged 14.1%.
Fifty-four percent of all U.S. banks saw year-over-year earnings growth in the first quarter.
Moving now to valuation, BB&T traded at a forward price-to-earnings ratio of 12.9, according to data form Capital IQ. That compares with the peer set average of 16.7.
BB&T's market cap is, at the time of this writing, 2.1 times its tangible book value. The peer set average was 1.9.
Many investors use a general rule of thumb of buying a bank stock when the price-to-tangible book value is less than 0.5 and selling when it rises above 2. For me, that method is just way too oversimplified.
It sometimes makes sense to pay a premium for a bank stock that places a high value on credit culture and asset quality. These banks will survive and prosper while others fall by the wayside. That security can be worth a premium. Likewise, a bank that relies heavily on leverage to achieve above-average return on equity may not be worth the price, even if price-to-tangible book value is low. That risk may not justify even a healthy discount in price.
Based on the factors we've discussed here -- soundness, profitability, and growth -- BB&T's valuation seems fair.
The company's forward P/E ratio appears low; however, its price-to-tangible book value seems fairly priced, given the company's conservative leverage and strong (but not outstanding) profits. The stock probably has some room to run as the portfolio of non-performing assets works its way out of the bank. At that time, management may decide to increase leverage, stoke growth, and move ROE closer to 15% or higher.
As such, I see BB&T as a sound long-term investment, even if the bank isn't currently trading at a discount.
Jay Jenkins and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.